Market Sees Tepid Growth As Taper Later Signal

Fundamental Coals Have Not Caught Fire

Those of you who have experience with old-school charcoal grills know lighter
fluid is used to prime the proverbial pump until the coals can take over. Quantitative
easing (QE) is the Fed's lighter fluid for the economy. The hope is that money
printing will help spark economic growth. Once economic growth picks up, the
Fed can put its lighter fluid away. The problem is if the Fed stops pumping
lighter fluid onto the economic coals, the present day fire may go out. Yahoo
Finance recently asked American economist Robert Shiller what keeps him
up at night, is it asset bubbles? His response speaks to the Fed's reluctance
to put the cap back on the lighter fluid:

"The world economy is softening a bit," he tells us in the accompanying
interview. "There's always a chance of another recession. It's been six
years since the last recession started - they tend to come along with some
regularity. Congress is now unable to get things done, and so we won't
have a good response if there's another recession."

How Important Are The Recent Cracks?

This week's video covers evidence of defensive posturing that has been slowly
creeping into the battle between economic confidence and economic fear. The
video puts recent gains in Treasuries (TLT), weakness in credits spreads, and
lagging performance from economically-sensitive stocks in perspective.

Rough Draft Wednesday's Fed Statement

With the recent less-than-stellar reports on the economic and earnings fronts,
it is difficult to see the Fed adding a "we are about to taper" clause to this
Wednesday's statement. From Bloomberg:

"Investors are going to be overly focused on this Fed meeting," Scott
Wren, senior equity strategist at St. Louis, Missouri-based Wells Fargo
Advisors LLC., which oversees about $1.3 trillion, said by phone. "I suspect
that when the statement is released there's going to be very little change
to it."

Therefore, we can use the last statement as a preview of this week's Fed event.
Below is a key portion of the statement released
on September 18:

Consistent with its statutory mandate, the Committee seeks to foster
maximum employment and price stability. The Committee expects that, with
appropriate policy accommodation, economic growth will pick up from its
recent pace and the unemployment rate will gradually decline toward levels
the Committee judges consistent with its dual mandate. The Committee sees
the downside risks to the outlook for the economy and the labor market
as having diminished, on net, since last fall, but the tightening of financial
conditions observed in recent months, if sustained, could slow the pace
of improvement in the economy and labor market. The Committee recognizes
that inflation persistently below its 2 percent objective could pose risks
to economic performance, but it anticipates that inflation will move back
toward its objective over the medium term.

Economy: Good and Not So Good

Monday brought some conflicting data on the economy. Industrial production
numbers looked good from a headline perspective, but has some concerning internal
elements. From CNBC:

U.S. industrial production recorded its largest increase in seven months
in September as utilities output surged after several months of declines,
but manufacturing showed signs of cooling. Industrial output rose 0.6 percent
last month after increasing 0.4 percent in August, the Federal Reserve
said on Monday. Economists polled by Reuters had expected industrial output
would rise 0.4 percent.

Worst In Three Years

In terms of looking at the broad U.S. economy, the housing market may be the
most susceptible to any tapering schedule devised by the Federal Reserve. In
the process known as quantitative easing, the Fed buys bonds to drive down
interest rates. When the Fed's demand for bonds is tapered, then interest rates
tend to go up. Rising interest rates means higher monthly mortgage payments
for homebuyers, which dampens demand for housing. From NBC
News:

Contracts to purchase previously owned U.S. homes fell by the most in
more than three years in September, a sign that a softer economy and a
rise in mortgage rates are hurting the country's housing market. Mortgage
rates have risen sharply since May on bets that the U.S. Federal Reserve
would soon begin winding down a stimulus program, although rates have eased
slightly in recent weeks. Many investors believe the Fed will keep its
bond buying stimulus at full throttle given recent signs the U.S. economy
lost a step in September.

Investment Implications - Stocks Tentatively Higher

The S&P 500 advanced 15 points last week. The stock market bears had taken
the S&P 500 down to near break-even with "return to risk-off" Wednesday.
The bears were not able to produce any follow through on Thursday or Friday,
which is indicative of a market where the desire to sell is relatively weak.

The chart below shows economic confidence is clearly in control relative to
economic fear. Points A and B highlight the 50-day and 100-day moving averages;
notice their slopes are beginning to rise again. Thus far, the S&P 500
has not stalled below resistance near point C. Points A, B, and C are all positive
developments for the economic and stock market bulls.

Would the stock market be going up if the Fed were not in the picture? The
answer is most likely no, but the Fed is an important part of the investing
equation. From Bloomberg:

It's premature to assume that yields are bound to increase after reports
last week signaled the U.S. economy still needs the Fed's support to ensure
its recovery, said Jack McIntyre, a Philadelphia-based money manager at
Brandywine Global Investment Management LLC, which oversees $44.5 billion.

The expectation of taper later is unquestionably impacting the market's
pricing mechanism. As we noted last Friday,
the present day market is in much better shape than it was during the 2007-2008
peaking process, allowing us to maintain exposure to economically-sensitive
investments, such as U.S. stocks (SPY), technology (QQQ), financials (XLF),
and emerging markets (EEM). However, the aforementioned cracks in the market's
profile must be respected allowing us to remain flexible.

Chris Ciovacco is the Chief Investment Officer for Ciovacco
Capital Management, LLC. More on the web at www.ciovaccocapital.com.

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